Bill Gross, who runs the world's biggest bond fund, contends that the Federal Reserve's open-ended plan to flood the economy with $40 billion a month will ignite inflation.
The options market is signaling that that won't happen anytime soon.
Demand to protect against higher yields on long-term bonds over the next six months has been static since Fed Chairman Ben S. Bernanke announced a third round of quantitative easing Sept. 13, Barclays PLC data show. Appetite for options that mature in 2015, however, is rising.
Traders' expectations for consumer price increases as measured by Treasury inflation-protected securities have fallen from the highest levels in 2006.
The market measures show that tame inflation is giving Mr. Bernanke time to nurse the economy back from the depths of the worst financial crisis since the Great Depression without pressure to withdraw stimulus just as $1.2 trillion in mandated fiscal spending cuts and tax increases start Jan. 1. Consumer prices are in check, though the Fed has pumped $2.3 trillion into the economy through QE bond purchases since 2008.
“The market is not suggesting there's any kind of runaway inflation in the next one or two years, given the below-trend growth trajectory and the impending fiscal cliff,” said Gemma Wright-Casparius, who manages the $43.9 billion Vanguard Inflation-Protected Securities Fund at The Vanguard Group Inc.
BOND RALLY
Treasuries have returned 41% since mid-2007 when reinvested interest is included, according to Bank of America Merrill Lynch indexes.
That is considerably better than the 7.52% gain for the S&P 500 with dividends.
Yields on 10-year notes fell 12 basis points in the last week of September to 1.64% in New York, according to Bloomberg Bond Trader prices. The price of the benchmark 1.625% security due August 2022 rose 1 2/32, or $10.63 per $1,000 face amount, to 99 29/32.
Even as speculation mounted in recent months that the Fed would undertake a third round of QE, a policy that risks igniting inflation by debasing the dollar and assets denominated in the currency, economists and strategists have grown more bullish on bonds.
The median of 78 estimates is for 10-year yields to end the year at 1.75% and finish 2013 at 2.4%. In April, the survey estimated yields at 3% by the start of 2014, still well below the average of about 7% since 1970.
Yields are down about one-quarter of a percentage point this year.
PAYER SKEW
The Barclays data measure what traders call the payer skew, using options on interest rate swaps. The skew typically widens when traders anticipate a rise in yields as they seek to hedge the value of their holdings.
It is now 25 cents for the shorter term, about unchanged from December, while it is 89 cents for options that mature in 2015, up from 80 cents at the end of last year. Each 10 cents represents $100,000 in bonds.
“The options market is pushing expectations of a violent sell-off in the Treasury market further into the future,” Piyush Goyal, a fixed-income strategist at Barclays, said last month.
He and his colleagues, including Amrut Nashikkar, were No. 2 this year in Institutional Investor magazine's survey of U.S. money managers in the category of best strategists for interest rate derivatives, behind JPMorgan Chase & Co.
FED PLAN
The Fed said Sept. 13 that it would buy $40 billion in mortgage bonds a month until the United States sees what Mr. Bernanke described as an “ongoing, sustained improvement in the labor market.”
The central bank also said that it would probably hold the federal funds rate near zero at least through mid-2015.
Since January, it had said that the rate was likely to stay low at least through late 2014.
Mr. Gross, who manages the $272 billion Total Return Fund at Pacific Investment Management Co. LLC, wrote on Twitter the day after the Fed's announcement that the central bank would “buy mortgages till the cows come home” and that investors should “buy real assets ... gold ... a house!”
He wrote Sept. 18: “We are in an age of inflation.”
Although Mr. Gross' fund gained 9.09% through the first nine months this year, beating 97% of its peers, it lagged behind in 2011 with a 4.16% return, underperforming 69% of rivals as he wrongly bet that Treasury yields would rise, data compiled by Bloomberg show. He cut the fund's holdings of U.S. government bonds last month to 21% of assets, the lowest level since last October.
ELECTION ISSUE
The Consumer Price Index rose 1.7% in August. Bond yields have been mostly below the gauge since April 2011, resulting in negative real yields.
The Fed's actions have become an issue in the U.S. presidential race.
Rep. Paul Ryan of Wisconsin, the Republican vice presidential candidate, said Sept. 12 that if former Massachusetts Gov. Mitt Romney is elected, he will focus on “sound money” to prevent stagflation, referring to an environment of low growth and high inflation last seen in the 1970s.
Investors initially increased their inflation expectations on the Fed's plan. The gap between yields on 10-year notes and same-maturity Treasury inflation-protected securities widened to 2.73 percentage points Sept. 17, the highest level since May 2006.
The so-called break-even rate, which measures how much traders anticipate that consumer prices will rise over the life of the debt, narrowed to 2.42 percentage points in the last week of September.
“The Fed will be proven right that hyperinflation will not be a consequence of their actions and that they will be able to execute an exit strategy well before those consequences may surface,” Wan-Chong Kung, a money manager at Nuveen Asset Management LLC, said late last month, referring to a tightening of policy.
Nuveen oversees more than $100 billion in bonds.
The Fed has built up three decades of inflation-fighting credibility, first with Paul Volcker and then with Alan Greenspan, with the CPI averaging 2.2% over the past five years, down from almost 15% in 1980.
“For the last 30 years, the central bank has done everything they can to increase inflation credibility,” Eric Green, global head of rates and foreign-exchange research at TD Securities Inc. and a former economist at the New York Fed, said last month. “Now they are withdrawing the deposit on that.”
WAGES, SPENDING
Mr. Bernanke is getting help from the weak labor market.
Wages grew 1.7% in August from a year earlier, down from more than 3.5% in early 2009. Consumer spending rose 0.1% in August after adjusting for inflation, following a 0.4% gain in July, the Commerce Department said Sept. 28.
“Our policy approach doesn't involve intentionally trying to raise inflation,” Mr. Bernanke said in response to a question during a Sept. 13 press conference. “The idea is to make sure we provide enough support so the economy will grow fast enough to bring unemployment down over time.”
The Fed's own measure of inflation expectations, the five-year, five-year-forward break-even rate, was 2.68% on Sept. 26, after reaching a 13-month high of 2.88% the day after the Fed's QE3 announcement. The gauge projects the expected pace of consumer price increases over the five-year period beginning in 2017.
Investors “pushing break-even rates higher are concerned about medium-term to longer-term inflation or, that is, two to five years from now,” said William O'Donnell, head U.S. government bond strategist at RBS Securities Inc., one of 21 primary dealers that trade with the central bank. “The inflation that we are pretty sure the Fed fears most, wage inflation, shows no imminent threat.”
